When describing some of the most common benefits of a commercial real estate investment, many investors are quick to cite the income, the tax benefits, or the potential for capital appreciation. While all of these are certainly important, they don’t account for one of the more commonly overlooked benefits, which is an inflation hedge.
In this article, we are going to define what inflation is, why it is important for investors to understand, and how a commercial real estate investment can protect against it. By the end, readers will have the information needed to determine if they would like to utilize commercial real estate as a hedge against inflation in their own portfolios.
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What is Inflation?
Inflation is the long term, gradual rise in the price of goods and services. Perhaps the easiest way to illustrate this point is with a non-real estate example, which is the price of Coca-Cola. From 1886-1959, a 6.5 ounce can of Coca-Cola cost just 5 cents. From 1959 onwards, the price steadily rose to the present day cost of around $1.19. The same trend also applies to big ticket items like houses, cars, furniture, electronics, and clothing.
The annual rate of inflation is impacted by a number of factors, but the most important is interest rates. When the economy is hot and demand is high, inflation tends to rise as competition for scarce goods and services causes prices to rise. In response, the government is likely to increase interest rates in an effort to curb economic growth and moderate price increases.
Monetary authorities (the Fed in the United States) typically try to manage inflation to a rate of 2%-3% annually, as measured by an index known as “CPI” or Consumer Price Index. But, there are times where it can go much higher, which is generally a bad thing for investors.
Why Does Inflation Matter for Investors?
From an investment standpoint, inflation matters because investors must try to make a return in excess of the rate of inflation or they may actually lose money on a “real” basis. For example, assume that an investor earns a return of 2%, but the rate of inflation is 5%. In this scenario, the investor actually “loses” 3% on their money because their dollars are able to purchase 3% less than they could the prior year. This is known as a negative real return.
When inflation is in the 2%-3% range, beating this can be done without taking a significant amount of risk. But, in a highly inflationary environment where the rate reaches 5%, 6%, 8% or even higher, investors must move up the risk spectrum to beat this rate and avoid losing purchasing power.
How Rising Inflation Rates Affect Real Estate Investments
As it relates specifically to real estate, rising inflation impacts real estate investments in a number of ways including interest rates, property prices, rents, appreciation, and historical debt. Each of these are discussed in detail below.
Rising Interest Rates
In times of high inflation, interest rates and mortgage rates tend to rise which leads to increased monthly payments for new real estate ventures. This impact can easily be seen through the arc of the COVID-19 Pandemic. At the outset, global monetary authorities attempted to increase consumer spending by making the cost of debt cheaper, in many cases cutting interest rates to 0%. In combination with significant financial stimulus and supply chain issues, the rising demand for goods and services caused inflation to accelerate – reaching a historical high of 9% at one point.
In response to this high inflation, the central bank’s first course of action is to raise interest rates to limit the supply of money in circulation. The impact of these increases are felt in mortgage rates, which causes monthly payments to rise in tandem. For example, suppose an investor decides to buy a property with a $400k mortgage that has an interest rate of 3.5%. With a 30-year term, the monthly payment would be ~$1,796. Now suppose the same investor wants to buy a house when rates have risen to 7%, the monthly payment would be ~$2,661. If their capital limits them to a monthly payment of $2,000, they would clearly have to opt for a lower priced property to stay within this range, causing demand to fall.
Rising Property Prices
As the price of consumer goods increases, so do the prices of real assets – like real estate. This is especially true in popular real estate markets where demand is high. For owners of commercial real estate in an inflationary environment, these increases are positive and can contribute to large capital gains.
However, it is important to note that rising property prices eventually weakens demand for existing assets, especially when the cost to finance those assets has risen with inflation.
Commercial properties are leased to business tenants, who pay rent for the privilege of occupying a space. This rental income is used to pay for the property’s operating expenses and debt service while anything left over is available to be distributed to investors.
In an inflationary environment, expenses rise, but the good news is that property owners also have the ability to increase rents to offset the impact of rising costs. In addition, income from distribution can be reinvested at higher interest rates to increase overall returns.
Limited Availability of Properties
Higher property property prices can lower the demand for commercial real estate assets due to higher financing costs, making the disposition of current assets more difficult.
The basic laws of supply and demand indicate that limited availability of properties are likely to drive prices higher, which benefits investors in the long run.
Many commercial real estate leases contain a “rental escalation clause,” which calls for periodic rent increases over time. This is both good news and bad news for real estate investors. The good news is that commercial real estate can increase rents, which results in an increase in the property’s income.
But, the bad news is that commercial lease terms can range from 5-15 years or longer. In a highly inflationary environment, annual rent increases of 2% or 3% will not keep up with inflation and the lengthy lease term means that owners may have to wait a long time for a market reset in rents.
Most commercial real estate assets appreciate with time, and historically speaking, largely outpace the historical inflation rate of approximately 3.8% in the United States (from 1960-2021).
Simply put, inflation drives prices up for everything, including commercial real estate. Over the long run, this can lead to significant capital appreciation.
While high inflation and high interest rates are seen as unfavorable for current debt markets, inflation is actually a positive for historical debt because it becomes less burdensome to service as inflation increases.
For example, suppose an investor purchased a $20MM retail shopping center with a $12 million fixed rate loan, 10-year term, 30-year amortization schedule, and 4% interest rate. The monthly debt service of $57,200 remains the same for five years, but the value of the investor’s money has decreased by the rate of inflation over the same time frame. Therefore, each time there is an inflationary period the relative cost of debt decreases.
So, Is Owning or Investing In Real Estate Good During Inflation?
Based on the points above, yes, owning or investing in real estate during periods of high inflation can be a good thing. But, it is important to remember that markets are volatile and each property is unique, so the benefits may not be felt evenly across all asset classes and property types.
Buying & Selling Property During Inflation
In an inflationary environment, property values and rental rates tend to increase. So, as the Federal Reserve continues to raise interest rates to combat high inflation, the cost of owning an existing property stays the same while its value increases.
For buyers and sellers of commercial real estate assets, this may lead to a difficult decision regarding the best time to buy or sell. As a general rule, the best course of action is to view commercial real estate investments as a long-term hedge against inflation rather than trying to time the market.
How to Invest in Real Estate During Inflation
Real estate investments that tend to thrive during high-inflation environments usually exhibit the following characteristics: short-lease duration, pricing power, and resilient demand.
Short Lease Duration
Some commercial properties use long-term leases with small annual rent increases, while others are for shorter durations. This means that assets with short-term leases have the ability to re-price rents according to market conditions and will outperform commercial real estate assets with long-term leases when inflation is high.
Investments that tend to be more inflation-resistant allow investors to pass price increases along to their customers. Multifamily investments are a good example of this because lease durations tend to be shorter than other asset classes, and landlords are able to price these rents accordingly.
Shorter lease durations only help an investment strategy if there are enough tenants to fill an investment property. Therefore, it is wise to consider investing in properties that will remain in demand even when prices are increasing rapidly.
The Future of Investing in Real Estate During Periods of Inflation
As we’ve discussed, investing in real estate can be a great hedge against inflation, but timing is critical to maximizing returns. Investors should be aware of current market conditions by equipping themselves with the best available property data.
For long-term investors, a high inflationary environment can provide a tailwind for property values. However, if inflation and rising interest rates lead to an economic downturn, property prices may see a drop in value as a result. Therefore, investors should consider their short-term and long-term objectives, the realistic holding period for a real estate investment, and the potential risks and rewards associated with each transaction.
Summary of How Inflation Affects Real Estate Investments
One of the commonly overlooked benefits of a commercial real estate investment is that they tend to be a good hedge against inflation because inflation causes the price of everything to rise, including real estate.
Because commercial property owners can pass on expense increases through higher rent in times of higher inflation, property values tend to keep up, preventing an erosion of purchasing power over the longer term.
Interested in Learning More?
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